The Right Way to Jump on the Dividend Bandwagon

If you needed one more reason to pay attention to a fund's expenses, the recent dividend tax cut out of Washington is it.

Dividends are now taxed at a 15% rate, instead of at ordinary income tax rates that used to run as high as 38.6%. But you can only take advantage of this rate reduction if you're actually receiving dividends. And if you own a fund with fat expenses, the dividends will be scarce.

A fund's expenses are deducted from dividends and other types of portfolio income, such as interest, before that money is distributed to shareholders. That means the fees come out of income first. So the more you pay in expenses, the less you'll ultimately receive in dividends.

You also have to make sure a fund is actually paying out stock dividends instead of income from securities like bonds or real estate investment trusts, or REITs. Bond interest, for one, is still being taxed as income -- at much higher rates than the new 15% on dividends.

When you're looking for a fund that will benefit from the lower taxes on dividends, you can start with the expenses. The average U.S. stock fund charges close to 1.5% a year. You'll want a fund that takes a lot less than that. If a fund owns enough dividend-paying stocks to have a 1.5% yield but its expense ratio is 1.5%, the fees essentially cancel out the dividend. And a dividend yield north of that isn't easy to come by these days. The S&P, after all, is only yielding 1.74%; the average mutual fund offers a mere 0.35% yield, according to Morningstar.

You should also check out a fund's portfolio to see if it owns dividend-paying stocks, rather than bonds or REITs. A fund's name is a good way to start looking. Equity-income funds usually invest in, you guessed it, stocks that pay dividends.

To shorten your hunt for funds that will take full advantage of the dividend tax reduction, here are some ideas.

If you want low expenses, you go to Vanguard. The fund company is known for keeping costs down -- way down. And its ( VEIPX) Equity Income fund is no exception. Its expense ratio is a scant 0.46%. With those rock-bottom costs, the fund delivers a dividend yield of 2.56%. This Vanguard fund's portfolio is full of classic dividend-paying stocks, such as energy and telecom companies. And shareholders will pay less in taxes on those dividends.

The ( PRFDX) T. Rowe Price Equity Income fund isn't quite as cheap as the one from Vanguard. But its expenses are still well below average at 0.79%. And its yield is well above average at 1.8%, according to Morningstar. The fund owns some of the same stocks, such as ExxonMobil ( XOM), that you'll find in the Vanguard fund. But longtime manager Brian Rogers will also buy stocks that have been beaten up by the market, like AOL Time Warner ( AOL).

If you're a Fidelity fan, that firm's ( FEQIX) Equity Income fund is another option with a similar profile: low expenses, big-name stocks, experienced management and an attractive yield. However, this fund is by far the biggest of these three funds, sitting on more than $18 billion in assets.

If you already own plenty of large U.S. stocks, an international fund could also benefit from the lower dividend tax. The dividends from international stocks will also be taxed at the 15% rate as long as a company's stock trades here in the U.S. as well. For example, the 3% yield on GlaxoSmithKline ( GSK) fits the bill because the company's stock trades on the New York Stock Exchange.

By extension, some of the stocks in a fund like the ( VEURX) Vanguard European Stock Index fund would fall under the lower tax rate.